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Are Your Investing Decisions Irrational?

This year's Nobel Prize in economics was awarded to three economists, two of whom hold opposite views of the stock market. One, Eugene Fama, believes the market is rational and efficient. He's the originator of the "efficient markets theory." The other, Robert Shiller, believes markets are inefficient, in large part because investors so often act in irrational ways. (Is it any wonder economics is known as the dismal science?)

Whether markets as a whole behave efficiently is hotly debated. But when it comes to individual behavior, it's clear that investors don't always base decisions on logic. In fact, our financial decision-making is so illogical in so many ways and on so many occasions that it has spawned an entire field of study. "Behavioral economists" spend their days identifying, trying to understand, and sometimes poking fun at the many ways our decision-making is disconnected from logic.

Here are some of the major "cognitive biases" that tend to run investors off the rails of rational thought. Also shown are examples of how they affect financial decision-making and ways you can keep these biases in check.

1. Anchoring. If you've ever been to a restaurant where the high price of a particular item—perhaps the "signature dish"—took you aback, you've experienced anchoring. Perhaps ordering that item would be one of the most enjoyable culinary experiences of your lifetime, well worth the price. More likely, though, you'll pass and order something else. Still, having that item on the menu plays an important role for the restaurant. It serves as an "anchor," making their other dishes appear to be a bargain, perhaps even influencing you to order something a bit more expensive than you would have otherwise.

Technically speaking, anchoring is the tendency to attach or "anchor" our thoughts to a reference point, sometimes even when the reference point has no logical relevance to the decision at hand. Anchoring also refers to our penchant for putting too much emphasis on the importance of initial information, with the first input serving as the point of comparison for all subsequent inputs.

In investing terms, one of the most obvious anchors is the purchase price of an investment. All of our subsequent decisions with that investment tend to be influenced by our initial purchase price. When paired with the next bias, that can make us hesitant to cut our losses and move on.

2. Loss aversion/prospect theory. In essence, losses have a much stronger emotional impact on people than equivalent gains—possibly as much as twice the impact.

This explains why many investors tend to sell their investments when the markets head downward, but also why they often wait so long before doing so. Having anchored their perspective on the purchase price, if and when they fall below that price, many investors first resist selling, dreading the idea of selling at a loss. But as the investment continues to fall, the fear of additional pain finally does cause them to sell.

To help combat this natural tendency to procrastinate, we have included a specific selling discipline in our Upgrading strategy. When a recommended fund drops out of the top 25% of its peer group, we replace it. Upgrading owes much of its success to this "time to sell now" signal that's built in. Of course, it's possible for an Upgrader to nevertheless ignore the sell signal and wait to sell, hoping to at least break even. We do all we can to discourage this because it's been proven to be counter-productive.

This tendency to feel losses more acutely than gains reinforces why it is so important to get your asset allocation right. Think of yourself as having an investing "emotional bank account." Every time you gain 5%, you put one coin in the account. But every time you lose 5%, two coins are removed. That's roughly what's happening to you emotionally as your investments gain and lose value. One who experiences a painful loss is likely to develop the next bias.

3. Risk aversion. While Warren Buffett's quote about fear and greed is well known ("Be fearful when others are greedy and greedy when others are fearful."), most people find it difficult to recognize profit opportunity in a sharp market decline. Instead, they succumb to fear.

The combination of loss aversion and risk aversion goes a long way toward explaining why, as the market climbed to record highs in the five years following the crisis of 2008, almost half (!) of investable assets stayed parked in cash, and this despite savings rates near zero. Even though the market has rebounded nicely, investors' emotions have not.

What's the best way to overcome anchoring, loss aversion, and risk aversion? Experience helps. But the most immediate way to take action is to develop a written investment plan. If created during a time of low emotional stress—and reviewed regularly at times of high emotional stress—a well thought out, long-term plan can go a long way toward keeping you on track when the strongest of cognitive biases are telling you to change course.